The demand for alternative investments among institutional clients remains strong, leading asset managers to focus on the space as a likely growth area, according to new research from Cerulli Associates. 

“Expectations regarding future capital market returns and the need to optimize risk-adjusted performance are the leading drivers of investors’ interest in alternatives,” explains Michele Giuditta, associate director at Cerulli. “With equity and bond valuations stretched, the potential diversification benefits and alpha provided by alternatives appear favorable on a relative value basis.”

These ideas are explored in depth in Cerulli’s most recent report, “U.S. Alternative Products and Strategies 2016: The Multiple Roles of Alternative Investments.” Analyzing behavior of asset managers that manufacture and distribute alternative products in the United States, the report observers rapid and significant development in the U.S. retail and institutional alternative product landscape. Worldwide alternative assets exceeded $7.5 trillion as of year-end 2015, Cerulli says, “with growth primarily driven by private equity, as fundraising remained strong.”

While alternative assets grew 36.6% in 2014, alternative mutual funds declined 11.0% in 2015, denoting the evolving character of the alternative market.

“Institutional clients (57%) remain the top channel from which managers are seeing demand for alternatives, followed by financial advisers (46%) and distributors/platforms (42%),” Cerulli reports. “On average, 37.3% of advisers are using alternatives and 38.7% are using liquid alternative mutual funds.”

Especially among the advisers using the products, alternatives still appear to be a relatively minor part of the toolbox: “Advisers’ mean allocation to alternatives remains at less than 5% of their assets, typically well below recommended amounts.”

NEXT: Alts appropriate for low and medium risk clients 

According to Cerulli, the majority of advisers are recommending that their moderate risk tolerance (45%) and low risk tolerance (38%) clients allocate between 6% and 15% of their portfolios to alternatives. This is still seemingly a far-off target—as alternatives represented just 3.2% of total mutual fund assets in the latest measurement.

“Managers expect liquid alternatives' market share to grow to 5.3% in two years, 7.8% in five years, and 11.7% in 10 years,” Cerulli explains. “Open-end mutual funds are the most widely used vehicle, as 85% of managers use this wrapper to package their alternatives.”

In terms of present demand, Cerulli finds more than 40% of managers received several requests for their multi-strategy (44%), absolute return (42%), and long/short equity (41%) liquid alternative products in recent months. Nearly one-third of managers also received several requests for their hedged equity and nontraditional bond products.

Given the demand seen by managers, it’s no surprise nearly all institutional investor types increased their mean allocations to hedge funds during 2015, Cerulli adds. “Pension plans account for 43% of the investors in hedge funds, with public pensions owning a growing share of assets under management—23% as of year-end 2015. Nonprofits are also an important source of capital for hedge fund managers. Endowments and foundations collectively own 21% of hedge fund AUM.”

Observing a related trend, Cerulli finds nearly half (47%) of alternative managers are integrating environmental, social, and governance (ESG) considerations into the investment decision-making process. “This number increases to 64% when only including respondents that offer private investments, confirming that ESG integration is more widely practiced among private investment managers.”

Information on obtaining Cerulli research reports is here.